Poulsen Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. No change in net operating working capital would be required. This is just one of many projects for the firm, so any losses on this project can be used to offset gains on other firm projects. The marketing manager does not think it is necessary to adjust for inflation since both the sales price and the variable costs will rise at the same rate, but the CFO thinks an inflation adjustment is required. What is the difference in the expected NPV if the inflation adjustment is made versus if it is not made?

Question

Quizplus · Accepted Answer

Inflation adjustment is required to account for the increase in sales price and variable costs; otherwise, the cash flows will appear to be higher than they actually are. By adjusting for inflation, the cash flows are brought to their present value equivalent, and the NPV can be calculated based on actual cash flows.

Without inflation adjustment, the expected NPV is $38,000, and with inflation adjustment, the expected NPV is $51,316.

The difference in the expected NPV is $13,316.

Poulsen Industries Is Analyzing an Average-Risk Project, and the Following